Educational Articles

Using the Value Line Page: Kraft’s New Growth Driver

Reuben Gregg Brewer
| January 28, 2011

The Value Line Timeliness Ranking System, a proprietary metric, appears at the top left of Value Line’s stock reports in the Ranks box. The measure assigns stocks a rank from 1 (Highest) to 5 (Lowest) across the approximately 1,700 stocks covered in The Value Line Investment Survey. Historically, these ranks have proven effective at predicting relative performance over a six- to 12-month period. The ranks are based on known financial information, including such factors as the 10-year trend of relative earnings and prices, recent earnings and price changes, and earnings surprises. With a Timeliness Rank of 4 (Below Average), Kraft Foods (KFT - Free Value Line Research Report on Kraft) isn’t a compelling purchase over the near term based on the factors within the Timeliness Model.

However, the ranks don’t take into account qualitative factors, such as acquisitions like Kraft’s purchase of Cadbury. Such deals often result in temporary weakness in the acquiring company, with merger costs often depressing results over the near term. Market concern about the deal living up to management projections can also result in an underperforming stock. As such, these factors can lead to poor near-term results at companies involved in mergers and, thus, to a low Timeliness rank.

Over the longer term, however, Kraft’s purchase of Cadbury has the potential to materially transform it as a company. Value Line analyst Justin Hellman devotes about half of the Analyst Commentary section of the most recent Value Line report for this company to the benefits of this massive purchase. The key points from the report are that it added new and valuable brands to Kraft’s portfolio; Cost synergies are likely as redundant functions are consolidated; and the combination adds valuable distribution routes and capabilities in emerging markets.

The last point is, perhaps, the most interesting as investors look for ways to capitalize on the expected growth of developing nations. Indeed, in 2009, prior to the merger, the company derived about 60% of its sales from North American markets (a fact that can be found in the Business Description of the page) – clearly, the other 40% or so of revenue is derived from abroad. Although definitive figures for the merged company won’t be available until Kraft files its 2010 10-K with the SEC, Hellman expects an increase in the percentage of foreign sales in the mid-to-high single digits. This would bring the total closer to a 50-50 mix. More importantly, the mix of developed to emerging market is likely to shift, since Cadbury had materially more exposure to developing economies than does Kraft.

This exposure makes a company like Kraft a conservative way to invest in what would otherwise be considered risky locales, including China and India. In fact, there are plenty of investment opportunities for those seeking pure play investments in these countries, but more conservative investors would likely shy away from the volatility and risk to which they would be exposed. Kraft, however, is far from volatile and risky. The stock earns Value Line’s best score for Safety (a proprietary measure that goes from a top score of 1 to a low score of 5), as can be seen in the Ranks box just under the Timeliness rank. Also in that box is the stock’s very low beta—0.65. Beta is a measure of volatility relative to the broader market and suggests that for a one percentage point move in either direction, Kraft shares will typically move just 0.65 of a percent.

In addition, the company earns the highest possible scores for Stock Price Stability and Earnings Predictability (both of these proprietary measures are in the Rates box at the bottom right of each report). The relatively low score for Price Growth Persistence highlights the lackluster long-term performance of the shares. However, the Cadbury acquisition has the potential to alter the company’s growth profile materially, so that backward looking measure may not be the best indicator of what the company is capable of in the future.

Also included in the Rates box is the company’s impressive A+ Financial Strength score (this is an important component of the Safety Rank). Although the company has a hefty debt load (nearly 50% of its capital structure, as the Capital Structure box shows), it handily covers the interest payments and has a relatively reliable revenue stream as it sells staple products (food). In addition, an examination of the Current Position box, which is directly below the Capital Structure box, shows that the company had some $2.3 billion in cash on the balance as of September—nearly double the level at the end of 2008.

Kraft’s strong financial base and expanded foreign market exposure make this an interesting investment option for more conservative investors looking to get involved in the expected growth of emerging markets. Hellman believes this trend will help push the company’s sales up about 3.5% on an annualized basis over the coming three to five years. Cost synergies, meanwhile, should allow Kraft to turn that revenue increase into earnings advances in the 8% range on an annualized basis. Both figures can be found in the Annual Rates box.

That earnings advance translates into earnings per share in the $3.00 range by 2013-2015. This figure can viewed in the far right column of the Statistical Array. It is made possible by what Hellman believes will be a 1.2 percentage point improvement in Kraft’s Net Profit Margin (the amount of money, after taxes, that the company earns relative to its sales). Clearly that improvement is expected to come from cost savings associated with the Cadbury merger.

The projected earnings of $3.00 per share translates into a price range of $45 to $55 over the three- to five-year period. That’s a price gain of 45% to 75%. Add in the company’s projected dividend payments over that span and the expected annual total return range is between 13% and 18% per year, on average. The price range and return figures can be found in the Projectionsbox and round out the potential Hellman sees with actual numbers.

For investors looking to participate in the expected growth of emerging markets over the next five to ten years, Kraft shares seem a relatively low risk way to gain exposure.

At the time of this article's writing, the author did not have positions in any of the companies mentioned.